DEALBOOK; Swap Market, Like Libor, Is Vulnerable to Manipulation

By JESSE EISINGER, PROPUBLICA

Published: July 19, 2012

The rate-manipulation scandal has demonstrated that banks will collude with one another for their own benefit.

Banks didn't report the rate at which they were borrowing from other institutions. They could report a made-up rate that, not surprisingly, turned out to serve their economic interests at the time.

So, it might come as a worry that there is another, multitrillion-dollar market - the credit-default swap market - that operates under a similar principle.

Credit-default swaps are insurancelike derivatives, or side bets, that protect investors from bad events like a company going bankrupt or a country failing to pay its debts.

Whether a company has defaulted on its debt might seem unambiguous to some na? souls out there. But that's hardly the case, especially when there are lawyers involved and billions of dollars at stake. Because credit-default swap contracts can be worthless when they expire, the timing of insolvencies can make the difference between making and losing a great deal of money.

Decisions about when a swap pays out are made by a trade group called the determinations committee of the International Swaps and Derivatives Association. The mere fact that a determinations committee exists is evidence that ''insolvency'' is not simple to define.

Sure, credit-default swaps are products for grown-ups. Sophisticated investors play in this market. Foster children and the infirm are not putting their life savings into this market directly.

But they matter to corporations and countries. When Europe tried to bail out Greece, an enormous debate sprang up about whether the restructuring of Greece's debt was technically considered a ''default.'' Initially, the committee said it wasn't. Then, after some details shifted, the committee ruled it was.

A proper market would want an organization that was impartial, regulated, transparent and open to appeal.

No such luck.

The determinations committee has 15 members, 10 of which are the major dealers in credit-default swaps, the giant banks that are effectively permanent members. One criterion for dealer members is that they trade a certain amount of derivatives. After the 2008 financial crisis, there are fewer such firms, and they have consolidated their influence and power over our capital markets.

The committee operates as a quasi-Star Chamber. It makes decisions without having to publish its reasoning and almost never has. There isn't any appeal process. The committee itself says it isn't bound by precedent.

In a terse statement last year about a decision that raised some experts' eyebrows, the committee gave the world some logic seemingly borrowed from the Supreme Court's ruling on Bush v. Gore: ''This statement is not, and does not purport to be, binding,'' the committee wrote, even if it were presented with another situation that ''relates to similar facts.''

In other words: Ask us again tomorrow and you might get a different answer.

The biggest concern is that there's no prohibition against committee members deciding cases in which they may well have an economic interest. There is no recusal process. Indeed, it is almost impossible for the major dealers to not have a stake in the outcomes, since they are the major dealers.

A spokesman for the association contended that ''there are safeguards built into the process which work to support integrity of process.'' The voting, if not the reasoning behind it, is publicly disclosed. The committee requires a supermajority for decisions, 12 of the 15 votes, so the dealers can't gang up on the other members. And it's entirely possible that banks might be on different sides of a trade, with some banks having sold protection and some having bought it. The hope would be that the conflicts of interest cancel each other out.

To the market's credit, there is no evidence that the process has become corrupted by big banks. Given the evidence of collusion in the rate-manipulation case, however, trusting it to remain that way doesn't seem like a good plan.

Oversight might be helpful here. But the new financial regulation under Dodd-Frank, while pushing most derivatives of the plain-vanilla kind onto clearinghouses, doesn't address this issue.

Sure, regulators can now get access to dealers' positions. And if that eases your concerns, I'm sure Barclays would like to make you a loan tied to the London interbank offered rate, the dubious benchmark at the center of the scandal.

Other remedies seem pretty apparent. Banks could disclose their positions ahead of rulings. The committee could issue its reasoning, which the association says it's planning to do. There could be an appeals process.

That banks haven't taken these steps yet is a display of the industry's casual disregard for any significant checks on their cartel businesses. It's a situation that has become so routine on Wall Street as to almost be unremarkable.

This is a more complete version of the story than the one that appeared in print.

PHOTO: Presidential guards at the tomb of the unknown soldier in Athens. The determinations committee of the International Swaps and Derivatives Association was involved in deciding whether restructuring Greece's debt was a default. (PHOTOGRAPH BY CHRIS RATCLIFFE/BLOOMBERG NEWS)